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Stocks & Commodities V. 25:7 (44-49): Double Diagonals And Butterfly Spreads by John A. Sarkett

Trading With Dan Sheridan (Part 3)

Double Diagonals
And Butterfly Spreads
DOUBLE DIAGONALS
TIM FOLEY

The third part of this series with trader Dan Sheridan looks
at double diagonals with long, protective wings one or more
months out from the short options, as well as the butterfly
spread, an income-generating strategy.
by John A. Sarkett
ouble diagonals are Dan Sheridans single fa-
In addition, the double diagonals strategy has a more favor-
able riskreward ratio than other income strategies 1:2,
1:3, 1:4, compared with 1:10 for condors. The yields can
reach 15% to 30% for 30 days on average.
Remember, this is a business An insurance company
without the overhead, as Sheridan says. Remember, he was
a market maker for 22 years. Everything he does is hedged,
quantified, managed, and managed in advance, managed in

D vorite strategy, and he likes to mix double

diagonals in a portfolio with condors for diver-
sification. Heres why: While increasing vola-
tilities hurts the condors, it helps the diagonals.
times of peace, not in times of war, as he puts it.

Best option candidates for double diagonal strategy

Stock is greater than $30
So one offsets the other. Lets look at double diagonals first.
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 25:7 (44-49): Double Diagonals And Butterfly Spreads by John A. Sarkett
OPTIONS

Implied volatility (IV) in lowest two thirds of its
two-year range

Nontrenders, sideways movers

Low volatilities (for nonmovers, we want to go
sideways)

Skews (volatilities near and far) in line, not more
than four points apart

Nonearnings months again, we dont want
movement due to news

Boring, sideways, predictable industries, no
biotech startups or the like.
Filter
1 Sell the call option strike (minimum 0.50 for short
option) in the front month that is the first strike
inside one standard deviation.
2 Sell the put option strike (minimum 0.50 for short
option) in the front month that is the first strike
inside one standard deviation.
3 Buy call one to two months out from short option
and up one strike (maximum one and a half times the
price of a short call).
4 Buy put one to two months out from short option and
down one strike (maximum one and a half times the
price of a short option).
5 If the profit/loss graph sags in the middle, then bring
the short and long options in one strike.
6 If a negative skew of greater than 2 exists (long
month minus short month), then dont do the trade!
7 If a positive skew of 4 or more exists, then investi-
gate.
8 Know the earnings date and past gap potential.
Case study
Heres a double-diagonal example that Sheridan gave his
option seminar session-goers. On October 13, 2006, with
Whirlpool (WHR) at $88.83, Sheridan:
Sold 10 Nov 95 calls
Bought 10 Dec 100 calls
Sold 10 Nov 80 puts
Bought 10 Dec 75 puts
Credit: $0.73 or $730
Risk: $5,000
The plan
Dan Sheridans strategy is:
1 Adjustment target points were set at Whirlpool 81
and 94. This is where the risk curve showed losses
gathering speed. If Whirlpool hits 81 or 94, roll
the credits.
Copyright (c) Technical Analysis Inc.
OPTIONVUE
FIGURE 1: THE DOUBLE DIAGONAL. When your long option is greater than one
and a half times your short position, you have a poor profit prospect.
2 When either credit can be taken off for less than 0.20,
do it.
3 When half of the initial cash flow can be closed out
as profit, do it.
MANAGING THE TRADE
As time goes on, the adjustment target points are brought in
closer and closer to the market; instead of protecting
breakevens, you are now protecting profits. Sheridan calls
this tightening the noose. After 15 days, the risk curve
shows that yield on the strategy drops after Whirlpool (WHR)
hits 84.50 on the downside, or 91.50 on the upside, so these
become the new adjustment points.
Another rule of thumb: Adjust at half the distance between
the short strike and breakeven. If you are expecting the trend
to abate, roll up (or down) your short strike that is, buy in
your short option and resell it higher (for example, buy in
short 55 near month, sell 60 call next month out).
If neutral, Sheridan adjusts by turning the double-diagonal
trade into a neutral calendar spread (buy in short 55 call near
month, sell 55 call next month out). If an adjustment cannot
improve the risk curve of the trade, he takes it off and moves
on to the next opportunity. He doesnt nurse a losing position
ever: Im not just hoping to make money every month.
This is a business. I have a plan to make money, he states.
On the November 17th expiration, WHR was 86.50. The
whole net credit spread premium was captured, and the
strategist still held the wings that is, the December 100
calls and the December 75 puts.
Major caveats
Here are some things to watch out for. Beware when:
While increasing volatilities hurts the
condors, it helps the diagonals. So one
offsets the other.
Stocks & Commodities V. 25:7 (44-49): Double Diagonals And Butterfly Spreads by John A. Sarkett

FIGURE 2: SAGGY BOTTOM. This is what happens when your long option is FIGURE 3: SELL LOWER CALLS AND HIGHER PUTS. Here, the 127s and 131s are
greater than one and a half times your short option. sold instead of the 126 and 132 to improve the profit-loss graph.

Your long option is greater than one and a half times

your short option (Figure 1). This will make for a
saggy bottom in the risk curve, a poor profit
prospect (Figure 2).

You are paying too much. To fix this, go back and
sell lower calls and higher puts to generate more
income. In Figure 3, the strategist sells the 127s and
131s versus the 126 and 132 to create a better profit-
loss graph.

And voil, the saggy bottom tightens (Figure 4).

You should not put double diagonals on during earnings
months. There is too great a prospect for a major move that
could turn a winner into a loser in one day.
What can you do when the stock gaps beyond the short
FIGURE 4: THE SAGGY BOTTOM TIGHTENS
strike? Close the position. I dont play games with these
things, Sheridan says.
Suppose a double diagonal is put on and the stock doesnt
meander sideways as was hoped, but moves a strong 5% up
or down within the first few days? Dan Sheridan advises
getting out at a small loss, with consideration toward reposi-
tioning the trade at a different level a week or so later if the
situation warrants it.

BUTTERFLY SPREADS
A short (or income) butterfly is selling two at-the-money
(ATM) calls, buying one call under and one call over, as in the
following example. Viewed on a monthly basis, it is a high-
yield vehicle (Figure 5).

Dan Sheridans income butterfly management checklist

1 Pick a low-volatility stock. Sheridans tip: The time
FIGURE 5: THE INCOME BUTTERFLY. Adjust points on an income butterfly can be
after earnings news has been digested is typically a
seen where the profit/loss points cross zero on the graph. Different lines represent
different points in time. When a trade starts to lose money, Dan Sheridan adjusts quiet, low IV time, and a good time to put on a
the trade by buying in the losing side, and placing the trade out further. butterfly.
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 25:7 (44-49): Double Diagonals And Butterfly Spreads by John A. Sarkett

2 A tactic for butterflies is to put on with four weeks

before expiration and tighten the noose or take off
at about two weeks before expiration. Tighten the
noose refers to setting adjustment points closer and
closer to the market to profit profits, as more and
more time is logged in the trade.
3 Maximum loss: Around a quarter to a third of what
you paid for the butterfly.
4 Buy butterfly 25 to 35 days till expiration.
5 Sell ATM strikes and buy long positions five to 50
points away, depending on the vehicle.
6 Set adjustment points at breakevens (BEs) at expira-
tion plus 1.5% of underlying for extra room (first two
weeks) (1.5% of 72.50 for IWM = 1.0875). Easiest
way to see the breakevens is to review the risk curve.
FIGURE 6: INCOME BUTTERFLY IN ACTION. Heres an example using iShares
7 Tighten the adjustment points to BEs for the last of the Russell 2000 index.
two weeks.
8 Tighten noose when up 20% on (at this point, have RUT: 50-point strikes
stop orders in no lower than 10% yields to take off). SPY: Five-point strikes
9 For OptionVue users, set slippage on small to 12 Be patient when putting on a trade. Use midprices
moderate when deciding when to get out. and cave in 0.05 if necessary.
10 At all costs, try to be out by Friday before expiration. 13 As Dan Sheridan says: Once you get more familiar
trading butterflies, your acceptable losses will be
11 Butterfly candidates:
based on what profits youre taking out of butter-
MDY: 10-point strikes flies in the good months. For example, if you find
IWM: Five-point strikes yourself taking 20% profits of $600 consistently
SML: 25-point strikes and not going for more, then maximum loss would
be around $600.
MID: 3040 point strikes

TRADER DAN ON OPTIONS ADJUSTMENT

An adjustment is changing your trade as the market changes.
You dont have to do it every month if youre selling at the
edge of standard deviation from the underlying, the way Dan
Sheridan does, but you have to do it, at least if you want to
treat options as a business and not as a gamble.
Adjusting is a peculiar advantage to the option market,
unlike straight-up futures or stock trading where stop-losses
and stop limits create gains or losses. Option adjustments
allow you to put the trade on again, often for another credit
offsetting a loss taken at the same time and giving yourself
more time for option decay to work for you. Adjustments can
be closing:

One part of a trade and putting it on again at a higher
or lower level that is, rolling, or

One leg of a trade out, or

The entire trade out.
Dan Sheridans general rules of adjustment include:
1 Pocket 50%. If your paper gain is greater than 50% of
your initial, take the trade off. Look elsewhere for your
next profit opportunity.
2 20-cent rule. If one of the credit spreads on a delta
neutral strategy (condors, butterflies, double diagonals)
can be removed for $0.20 or less, take it off.
3 20 delta rule. If delta has shot up to be greater than 20
on a sold option, take that side off. Roll it to a strike
where delta is 3-7 again.
4 1.5 x cash flow rule. Hard and fast rule: Never lose
more than one and a half times your cash flow. If your
paper loss is one and a half times your credit, take it off
and take the loss.
5 15-day rule. If you must adjust within 15 days of
expiration, close the trade. You are too short of time,
there is too little theta vis--vis too much potential delta,
or movement, and hence too much risk in the trade.
6 Two-roll rule. Roll down at most two times. If more is
required, then forces bigger than me are at work, and
Ill stand aside, Dan Sheridan says.
7 Adjustment cash. Keep 10% of your trading account in
cash for adjustments.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 25:7 (44-49): Double Diagonals And Butterfly Spreads by John A. Sarkett
OFF THE BEATEN TRACK: Q&A WITH TRADER DAN
Q. Why do calendars and butterflies, why not just buy puts
and calls? Or better, why not just sell naked options?
Dan Sheridan: Because over time, youll lose. Youll get
your ears ripped off. You want to put the odds in your favor,
and you want to manage risk, if youre serious about being in
the options business over time.
Q. How do you handle assignments?
Dan Sheridan: Most of the time when an option goes in
the money, we have adjusted before that time, so we are not
facing assignment. On those rare occasions we do get as-
signed, we are protected by the opposite option transaction.
Q. Do you enter condors, calendars, and butterflies as
spread orders, or do you leg in?
Dan Sheridan: Most times we will leg in. I know this is
contrary to what many teach. But as a market maker, I know
you will stand a better chance of getting better prices for your
spread by putting it together as component parts than as a
complete spread. Price your option in the middle of the bid
and ask, and cave in a nickel and no more. Heres the problem
with spread orders. If you have a good idea and send it to the
market, many times the market maker will look at it, say
Good idea. Id like to do it, too, and put it on the bottom of
the stack where it will gather dust. Index spreads are not
traded at six markets like equity options (AMEX, BOX, CBOE,
ISE, PHLX, PSE); there is a lack of competition to fill your
order.
Q. Ive been taught to sell high volatility and buy low
volatility, as a rule. Is this correct?
Dan Sheridan: No! High volatility means there is a
Case study
Heres an example using iShares of the Russell 2000 index
(IWM) (see Figure 6). On September 21, 2006, Dan Sheridan:
Bought five 67 calls
Sold 10 72 calls
Bought five 77 calls
The total debit was $1,070.
The longer the market stays around the center strike for
example, for IWM, 72 the more profitable the trade be-
comes. The risk curve of this trade is displayed in Figure 7.
Sticking with his discipline to be out of the trade two weeks
before expiration, Sheridan was able to generate a 17% return
on invested capital from September 29 to October 11 (20
days). (See Figure 8.)
It is important to note that IWM closed on October 20, 2006
(expiration), at 75.60. Had Dan Sheridan sat on the trade he
Copyright (c) Technical Analysis Inc.
tornado in the air. The market is saying something is going to
happen, trust the market. When trading spreads, buy and sell
volumes that are in line. If the difference between options is
more than six points, investigate, or since life is short
just look elsewhere.
Q. What is the weekend theta drop?
Dan Sheridan: Retail customers think theyll come in the
market on Friday and sell the options and pick up two days of
theta for free. Market makers are onto this. As market makers,
we used to start lowering volatilities to cover this Friday
mornings. So be aware.
Q. Whats the single most important thing to keep in mind
when trading options?
Dan Sheridan: Thats easy. Have a risk management plan.
Be prepared for the position to move against you, dont be
bushwacked by it and sit there frozen in the headlights like
Bambi. Know your adjustment points on each and every trade
when you put on the trade. Have your contingency orders in
the market immediately after your trade is filled. Make it a
business, not a speculation. None of this Im going to watch
it, or Im going to take the pain. Do your planning in times
of peace, not in times of war. If you do that, youll do well
over time.
Q. Any special thoughts on brokers?
Dan Sheridan: I recommend brokers who can take contin-
gency orders, offer spread order capability, and charge $1 per
contract or less. These are typically the options brokerage
specialists, and there are some four or five of these in the
market at the present time.
FIGURE 7: RISK CURVE OF THE INCOME BUTTERFLY. The longer the market
stays around the center strike, the more profitable the trade becomes.
Stocks & Commodities V. 25:7 (44-49): Double Diagonals And Butterfly Spreads by John A. Sarkett

FIGURE 9: SPECULATIVE BUTTERFLY. Dan Sheridan refers to these as time

bombs.
FIGURE 8: THE CLOSER TO EXPIRATION, THE GREATER THE RISK. Since the
trade was closed two weeks before expiration, Sheridan was able to generate a 17%
return from September 29, 2006, to October 11, 2006.

would have lost, as the risk curve shows. The closer the
option is to expiration, the greater the risk. Sheridan manages
risk. When he can avoid it altogether, he does so.

SPECULATIVE BUTTERFLIES
Dan Sheridan calls speculative butterflies time bombs. For
a very small investment, a high risk-reward profile can be
generated. Put these on before earnings; high volatilities are
acceptable. In this case (Figure 9), Sheridan:
Sells two 1280 puts, 2.54 each, total 5.08
Buys the 1295 put, 4.89
FIGURE 10: PROFIT-LOSS CURVE OF THE SPECULATIVE BUTTERFLY. The
Buys the 1265 put, 1.24
profit-loss curve looks like this.
Net debit: $1.05

The profit-loss curve looks like what you see in Figure 10.
A $1,050 investment in this bearish strategy could return as SUGGESTED READING
much as $14,000, a 1:13.3 riskreward ratio. Sarkett, John A. [2007]. Extraordinary Comebacks: 201
Inspiring Stories Of Courage, Triumph, and Success,
John Sarkett is the designer of Option Wizard Scan (options) Sourcebooks.
and Scan Wizard (stocks) software and writes about financial http://option-wizard.com
markets and other topics. His new book, Extraordinary Come- www.cboe.com/LearnCenter/webcast/archive.aspx
backs, includes chapters on business and finance. S&C

Copyright (c) Technical Analysis Inc.

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